What is meant by the carry trade

Assignment Help Macroeconomics

Reference no: EM131519684

Questions -

Q1. Explain how you could make profits from arbitrage if the forward exchange rate (F_B/C) is equal to 1.02 and your expectation of the exchange rate one year from now (E^A_B/C) equals 1.05. Assume that you are able to borrow $1,000,000 from a local bank and that there are no brokerage or transaction fees. Calculate the amount of profits you could make.

Q2. Exchange rates are often summarized in a matrix that lists all the exchange rate combinations between a set of countries.

The columns list the exchange rate in terms of home country currency per foreign currency, where the column heading is the home country. The rows list the exchange rate in tern of foreign currency units per home currency, where the row heading is the home country. For example, a exchange rate matrix where there are three countries, A, B and C, would look as follows:

	Country
	A	B	C
A	E_A/A	E_B/A	E_C/A
B	E_A/B	E_B/B	E_C/B
C	E_A/C	E_B/C	E_C/C

Suppose you have the following information about the exchange rates for country C:

	Country
	A	B	C
A	E_A/A	E_B/A	.8
B	E_A/B	E_B/B	.5
C	E_A/C	E_B/C	1

Complete the rest of the table assuming that triangular arbitrage holds.

Q3. Use the information below to answer question 3.

	L	M	Y
U.S.	.1	2,000	10,000
U.K.	.04	500	5,000

a. Calculate the price levels in both the U.S. and the U.K. according to the quantity theory of money.

b. Calculate the nominal exchange rate (dollars per pound) assuming the quantity theory of money and absolute PPP.

Q4. The table below provides information about the U.S. and European price levels and nominal and real exchange rates. Complete the table for year 2 assuming that relative PPP holds and that inflation is 4% in the U.S. and 1% in Europe.

Q5. China now fixes the value of its currency, the yuan, to the U.S. dollar. Output growth in the U.S. is 3%, inflation is 1% and money supply growth is 4%. Output growth in China is 7%. Assume that money demand (L) is constant in both countries. Assume that the quantity theory of money and relative purchasing power parity holds.

a. What should money supply growth be in China if China wants to fix its currency to the dollar?

b. Bonus. Assume that money demand (L) is growing by 2% in China but is constant in the U.S. If money supply growth is el in the U.S. but 12% in China, calculate the growth in the U.S.-China exchange rate (E_US/China).

Q6. The textbook presents a "Big Mac Index" showing the cost of a Big Mac in different countries. Create your own index of the cost of the cost of a good or service in the U.S. and two other countries using the internet to find prices. Examples of a service is the cost of hotel room using hilton.com or the cost of a rental car, using avis.com. In each case, find the local price expressed in the local currency, and convert into dollars using the exchange rate. Then calculate the real exchange rate as the foreign price expressed in dollars divided by the U.S. price. Exchange rates can be found on usforex.com but they are also available on many other sites. When comparing prices across countries, try to keep the good or service as similar as possible; for example compare the a room with two double beds at the same hotel chain. Report the good or service you are using, the local price, the exchange rate, the price in U.S. dollars, and the real exchange rate.

Q7. Suppose money demand can be described as M/P = 120 - 400i, where i is the nominal interest rate. Assume that the expected future exchange rate equals 2 and that the foreign interest rate equals .05.

a. Suppose the price level equals one and the nominal money supply equals 100. Calculate the nominal interest rate.

b. Calculate the spot exchange rate. Hint: remember that uncovered interest parity says that the domestic interest rate must equal the foreign interest rate plus the expected exchange rate appreciation.

c. Suppose there is a temporary increase in the nominal money supply to 110. Assume that the price level remains at one. Calculate the new nominal interest rate.

d. Calculate the now spot exchange rate. (Hint: use the same procedure as part b). Now assume that the increase in the money supply in part c was permanent, not temporary. The foreign country interest rate has not changed.

e. Suppose after one-year the price level has increased from 1 to 1.02. What will be the value of the interest rate?

f. What will be the value of the price level in the long run? (Hint: assume the quantity theory).

g. What will be the value of the exchange rate in the long run? (Hint: use your answer in part f and PPP).

Q8. Bonus. Read the article "The Carry Trade" and answer the following questions:

a. What is meant by the carry trade? What international economics principle appears to be violated by the carry trade?

b. What is one possible explanation for why the carry trade was profitable 2003 and 2010?

Reference no: EM131519684

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